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Monday, May 10, 2010

The Value Of The Right Incentives

Value investors have no problem investing in a company in which the manager controls a substantial stake - as long he also owns a substantial stake. If his own capital is committed, a manager is likely to make decisions which are in the best interests of other shareholders. On the other hand, if that manager is making decisions without consequence to his personal financial position, the incentives are not properly aligned: he's just playing with other people's money, like a mutual fund manager.

This is one of the few areas where value investors and the mainstream finance industry are in agreement. But how much is the removal of a "control-without-ownership" structure worth? By looking at a recent example, we can come up with an estimate.

Magna (MGA) is a global auto parts supplier we have previously discussed. Last week, the company announced a proposed deal between Frank Stronach (founder and controller) and the remaining shareholders, which Stronach has agreed to and on which shareholders will vote. Currently, Stronach only owns about 1% of the company's shares, but controls 66% of the shareholder votes!

So what would Stronach receive in return for relinquishing control? Not less than $300 million in cash, and 9 million regular shares, which is more than 10 times the number of shares he owns now! This package is worth almost $900 million, and that's not the end of it.

In addition, Magna will contribute $220 million for a 73% stake in a venture Stronach will...control! In other words, the control-without-ownership is being purchased from Stronach in part by giving him another business (in the growing field of hybrid and electric vehicle technology) where he has control without ownership!

The value of control without ownership should not be underestimated. As seen in this example, control of a company without the accompanying capital commitment is worth a substantial amount! Furthermore, the terms described above do not appear to be an overpayment, as Magna's stock price reacted very positively to the news in an otherwise down market.

As an example of the type of shenanigans that can take place in such control-without-ownership situations, Stronach has instituted consulting contracts with companies to which he is affiliated whereby Magna pays out 3% of its pre-tax profits to these firms every year! To remove Stronach's right to execute such contracts, shareholders now have to pay dearly.